The US Repo crisis is something that seems to turn up every day, or if you prefer as often as we are told there is a solution to trade war between the US and China. On Friday the New York Federal Reserve or Fed provided another US $72.8 billion of overnight liquidity in return for Treasury Bonds ( US $56.1 billion) and Mortgage-Backed Securities ( US $16.7 billion). So something is still going on in spite of the fact that we have two monthly plus Repos ( 42 days) for US $25 billion each in play and 3 fortnightly ones totalling around US $59 billion. So quite a bit of liquidity continues to be deployed and this is before we get to the Treasury Bill purchases.
In accordance with this directive, the Desk plans to purchase Treasury bills at an initial pace of approximately $60 billion per month, starting with the period from mid-October to mid-November.
As an example Friday saw some US $7.525 billion of these bought. So the sums are getting larger.
How did this start?
The Bank for International Settlements or BIS which is the central bankers central bank puts it like this.
On 17 September, the secured overnight funding rate (SOFR) – the new, repo market-based, US dollar overnight reference rate – more than doubled, and the intraday range jumped to about 700 basis points. Intraday volatility in the federal funds rate was also unusually high. The reasons for this dislocation have been extensively debated; explanations include a due date for US corporate taxes and a large settlement of US Treasury securities. Yet none of these temporary factors can fully explain the exceptional jump in repo rates.
Indeed, as for a start the issue has proved to be anything but temporary.
Where the BIS view gets more interesting is via the role of the banks or rather a small group of them.
US repo markets currently rely heavily on four banks as marginal lenders. As the composition of their liquid assets became more skewed towards US Treasuries, their ability to supply funding at short notice in repo markets was diminished.
As the supply of reserves fell in the QT or Quantitative Tightening era they stepped up to the plate on a grand scale.
As repo rates started to increase above the IOER from mid-2018 owing to the large issuance of Treasuries, a remarkable shift took place: the US banking system as a whole, hitherto a net provider of collateral, became a net provider of funds to repo markets. The four largest US banks specifically turned into key players: their net lending position (reverse repo assets minus repo liabilities) increased quickly, reaching about $300 billion at end-June 2019 . At the same time, the next largest 25 banks reduced their demand for repo funding, turning the net repo position of the banking sector positive (centre panel, dashed line).
So things became more vulnerable as we note this.
At the same time, the four largest banks held only about 25% of reserves (ie funding that they could supply at short notice in repo markets).
Then demand for Repo funding was affected by the US Treasury.
After the debt ceiling was suspended in early August 2019, the US Treasury quickly set out to rebuild its dwindling cash balances, draining more than $120 billion of reserves in the 30 days between 14 August and 17 September alone, and half of this amount in the last week of that period. By comparison, while the Federal Reserve runoff removed about five times this amount, it did so over almost two years
As you can see the drain from QT was added to in spite of the fact that the market had become more vulnerable due to the lack of players. There was a clear lack of joined up thinking at play and perhaps a lack of any thinking at all. A factor here was something the BIS identifies for the banks.
For instance, the internal processes and knowledge that banks need to ensure prompt and smooth market operations may start to decay. This could take the form of staff inexperience and fewer market-makers, slowing internal processes
After a decade the experienced hands had in general moved on.
But it was not enough to collapse the house of cards. There were other nudges as well on the horizon.
Market commentary suggests that, in preceding quarters, leveraged players (eg hedge funds) were increasing their demand for Treasury repos to fund arbitrage trades between cash bonds and derivatives. Since 2017, MMFs have been lending to a broader range of repo counterparties, including hedge funds, potentially obtaining higher returns.
So hedge funds were playing in the market but as it happened were not an issue for a while as the US Money Market Funds (MMF) turned up. But then they didn’t.
During September, however, quantities dropped and rates rose, suggesting a reluctance, also on the part of MMFs, to lend into these markets. Market intelligence suggests MMFs were concerned by potential large redemptions given strong prior inflows. Counterparty exposure limits may have contributed to the drop in quantities, as these repos now account for almost 20% of the total provided by MMFs.
So there is a hint that maybe a hedge fund or two became such large players that they hit counterparty limits. Also redemptions from MMFs would hardly be a surprise as we note the interest-rate cuts we have seen in 2019.
Why should we care?
There is this.
Repo markets redistribute liquidity between financial institutions: not only banks (as is the case with the federal funds market), but also insurance companies, asset managers, money market funds and other institutional investors. In so doing, they help other financial markets to function smoothly.
So they oil the wheels of financial markets and when they don’t? Well that is one of the causes of the credit crunch.
The freezing-up of repo markets in late 2008 was one of the most damaging aspects of the Great Financial Crisis (GFC).
In case you did not know what they are.
A repo transaction is a short-term (usually overnight) collateralised loan, in which the borrower (of cash) sells a security (typically government bonds as collateral) to the lender, with a commitment to buy it back later at the same price plus interest.
Also it is one of those things which get little publicity ( mostly ironically because they usually work smoothly) but there is a lot of action.
Thus, any sustained disruption in this market, with daily turnover in the US market of about $1 trillion, could quickly ripple through the financial system.
Some of the factors in the Repo crisis were unpredictable. But it is also true that the US Fed was at best rather flat-footed. There had been a long-running discussion over the use of Interest On Excess Reserves or IOER to banks on such a scale which was not resolved. Then there was the way that so few banks (4) were able to become such large players creating an obvious risk. Then the role of the MMFs as by their very nature they flow into and out of markets and are likely to flow out when interest-rates are declining.
The BIS analysis adds to what we know but changes in stocks give us broad trends rather than telling what flowed where or rather did not flow on September 17th or since. As David Bowie put it.
Turn and face the strange
Don’t want to be a richer man
Turn and face the strange
There’s gonna have to be a different man
Time may change me
But I can’t trace time
The BIS has been looking into some other areas.
Average daily turnover of OTC interest rate derivatives more than doubled over 2016-19 to $6.5 trillion, taking OTC markets’ share to almost half total trading
30 years, 53 countries, 1,300 reporting dealers, and $6.6 trillion daily FX trades,